When we learned of some big changes in tax deferral rules for 401(k)s and Roth IRAs, we asked private wealth advisor Edward T. Kelly, CFP®, CLU®, ChFC® to give our readers some details as we approach year end tax planning time. Here’s what we learned:
The IRS released positive news last Fall regarding converting after-tax monies in your 401(k) plan to a Roth IRA, tax-free (known as IRS Notice 2014-54). A 401(k) after-tax conversion allows earners a chance to build funds in a Roth IRA while still allowing the ability to maximize pre-tax or Roth 401(k) salary deferrals. Income limits prevent some earners from making direct contributions to a Roth IRA and while they may convert a traditional IRA to a Roth IRA, the tax consequences can be significant. Roth IRAs are one of just a few ways to accumulate tax-free wealth.
Many large employer-sponsored 401(k) retirement plans allow participants to make after-tax contributions to their 401(k). After-tax contributions to a 401(k) plan are not subject to the contribution limits that apply to pre-tax or Roth deferrals (i.e. $18,000 this year or $24,000 if you are age 50 or over). They do, however, count against the overall contribution limit of $53,000 (or $59,000 for those 50 and over) for 2015. This overall limit includes all employee contributions and employer matches that are made to the participant’s account.
The after-tax contributions to a 401(k) account can be removed from the plan via an “in service distribution” (at any age), transferred to a Roth IRA and repeated as often as the plan allows. One of my core philosophies involves diversification into three tax “buckets” wherein your assets can be classified as taxable, tax-deferred, or tax free. Many approach retirement with the majority of their nest egg in the tax-deferred bucket for which every dollar may be 100% taxable upon distribution. The after-tax 401(k) to Roth IRA conversion strategy allows you to build tax-free monies for greater flexibility, tax control, and compounded tax-free growth.
To convert your 401(k) after-tax money, verify that this activity is allowed by your plan with your plan administrator. And while this is after-tax money that could be converted, it is still a tax-reportable event, so contact your tax preparer to verify this strategy makes sense for you now and in the long-term.
